Reits claim credit crunch is a rite of passage

The outlook for commercial property was euphoric - but then came the sub-prime crisis and everything changed, says Sophie Brodie

A year ago, the UK's largest property companies were preparing to become real estate investment trusts. The tax-efficient vehicle would be exempt from additional capital gains tax on property sales so long as more than 90pc of earnings were distributed to shareholders.

Meanwhile, government would benefit from a windfall of billions of pounds as companies paid a one-off charge to switch to Reit status. It was, in the words of one property chief, "a no brainer".

As a result, property shares, already pumped up by years of cheap money and an influx of overseas investors, climbed ever higher as conversion approached.

But almost a year on, how have the new Reits fared? Badly, is the short answer. The shares have lost more than a third of their value while asset trading has ground to a halt.

Capital values, where they can be measured, have plummeted. Outside London values have plunged 20pc, in the City of London they are down 10pc to 15pc and in the West End about 5pc - despite almost record levels of occupancy. What began as a gentle slowdown in July has been quickened and deepened by the liquidity crunch. A heavy gloom hangs over the market and every day brings more bad news.

This week CB Richard Ellis reported a 4pc slowdown across all property in November while JonesLangLaSalle said it expected total transaction volumes for the year to be down 24pc to £48bn. Yesterday Savills released data showing that its development index had turned negative for the first time since May 2003.

Tomorrow the Investment Property Databank, the industry index, releases figures for November showing total property returns. After a fall in October, they are expected to be down again, this time between 2pc and 4pc.

Open-ended property funds have already felt the effects. Several have imposed three to 12 month limits on redemptions while New Star has slashed the value of its flagship UK fund by over 8pc. The sharper the correction, many hope, the sooner the recovery will begin - perhaps as soon as next summer. Unfortunately, there is no evidence the pain will be short-lived.

Harm Meijer, analyst at JP Morgan, said: "The property market is suffering from a double whammy. Not only is credit becoming more expensive but there is the prospect of an economic downturn and lower rental growth. We haven't reached the bottom yet."

Property chiefs too are cautious. Stephen Hester, chief executive of British Land, said: "Property is the tail on the donkey of broader world markets. If credit markets return to a state of calm in the first quarter of next year then real estate will follow relatively quickly."

Ian Coull, chief executive of industrial estates specialist Segro, said: "There is a strange paradox about this downturn. All other property cycles were led by a slowdown in occupier demand. But this one is the result of turmoil in the financial sector that has affected all asset classes."

Positive fundamentals, however, continue to be ignored on fears they will reverse. Property share prices fell again yesterday despite moves by central banks to pour liquidity into global markets and the derivatives market continues to predict a 17pc fall in values in 2008.

As a result of their pummelled share prices, all of the big Reits are tipped for takeover, namely Hammerson, and Land Securities, especially since it announced plans to break into three specialist companies - retail, London offices and outsourcing. Sovereign funds top the predators' list but large private equity firms are not being dismissed despite the credit freeze.

Meanwhile, analysts see British Land as the best candidate for recovery next year, mainly because its share price has fallen the furthest of the large Reits - 45pc. The company has been punished for its higher than average gearing and exposure to the volatile City office market. Institutions suffering from the credit squeeze faced with the choice of cutting dividends or selling property will inevitably opt for the latter.

Amid this uncertainty, the initial ambitions of new Reits that so excited investors last December have become irrelevant. After all, who cares about paying less tax when profits have halved. Nonetheless, as Mr Hester points out: "The goals for Reits have always been long-term and you can't measure performance over one year when there has been dis-investment. At least with Reits you have liquidity - unlike open-ended funds."